The Texas Supreme Court recently issued an opinion with implications for negotiating terms in power purchase agreements in the renewable energy market. In FPL Energy LLC, et al. v. TXU Portfolio Management Co., LP, the Court examined the nature of electricity as a good, finding it should be treated no differently than any other commodity when interpreting contracts. 2014 WL 1133329 (Mar. 21, 2014). The Court further considered and rejected as unenforceable a liquidated damages provision because it had no rational relationship to the actual damages, overturning a $29 million damages assessment.
In 1999, the Texas Legislature sought to increase the use of renewable energy sources in Texas. The Legislature directed the Texas Public Utility Commission ("PUC") to establish minimum requirements for renewable energy production and to develop a renewable energy credit ("REC") marketplace. Electric providers who are unable to meet requirements may purchase RECs in lieu of electricity generation through renewable sources.
In FPL Energy, TXU Electric ("TXU") contracted to purchase electricity and RECs from three wind farms owned by FPL. FPL failed to deliver enough electricity and RECs to TXU to satisfy its contract. After TXU sued FPL, FPL argued it could not meet its contractual requirements because the power grid was congested, or in other words, the grid lacked capacity to transmit all of the energy in a certain area. When the grid is congested, a state agency issues curtailment orders to facilities to cease production. FPL received such orders and produced less energy. FPL claimed that TXU bore the responsibility for the limited energy production because TXU was responsible for ensuring transmission capacity for all of the energy that FPL produced.
The Court's analysis focused on two issues: (1) whether TXU owed FPL a duty to provide sufficient transmission capacity for FPL's energy production; and (2) whether a liquidated damages provision in the parties' contract was enforceable.
Electricity Nothing Special—No Duty to Ensure Capacity
The Court found that the parties' contract placed the risk of a congested grid on FPL. In interpreting the contract, the Court found that the location of the electricity was a driving factor in the contract's risk structure. Specifically, the Court explained that TXU's transmission obligations arose only when FPL's electricity actually reached a certain delivery point. But electricity generation, transmission, and distribution occur almost simultaneously, making it difficult to pinpoint the electricity's physical location. The Court found that even if electricity moves too fast for the parties to truly physically pinpoint its location, the parties could "conceptualize" the location to negotiate contracts and to assign risk. Accordingly, the "unique nature of electricity" did not impact the Court's contractual analysis.
REC a Distinct Commodity
In interpreting the liquidated damages provision in the FPL-TXU contract, the Court found that it applied only to RECs because it did not mention "electricity." After examining the entire contract, the Court concluded that the omission of electricity from the liquidated damages provision was deliberate. Limiting the liquidated damages provision to RECs advanced stability in the renewable marketplace. RECs and electricity are unbundled—electric providers may generate either renewable energy or purchase RECs on the open market. In short, the Court recognized that RECs and electricity are two separate commodities that may be contracted for separately (though in this case they were not). Because the plain language of the FPL-TXU contract was clear, the Court refused to ascribe additional meaning to a REC, and noted that to do so would create uncertainty regarding the desirability of electricity/REC investments, impact the negotiation of future contracts, and impede regulatory compliance.
Enforceability of Liquidated Damages
A shortfall in RECs triggered liquidated damages of the lesser between $50 per deficient MWh or two times the market value of each deficient REC if the PUC had made a determination of market value. At the time of FPL's failure to deliver, the market value of a REC ranged from $4 to $14, but the PUC had not made a determination of the same.
A liquidated damages provision must be a reasonable forecast of just damages. A liquidated damages provision may be unenforceable if the actual damages incurred are less than the amount contracted for. Importantly, the reasonableness of an actual damages forecast should be analyzed as of the time of contracting.
At the time of contracting in FPL Energy, there was no REC marketplace, and thus no market value. The $50 per MWh option represented the PUC's actual penalty for failing to meet renewable requirements. At the time of calculating liquidated damages, the PUC had not made a determination of market value, and so the $50 per MWh was initially used in the liquidated damages calculation.
The Court, however, found that applying the liquid damages provision to the facts of the case rendered it unenforceable as a penalty. The Court explained that $50 per MWh did not tie the damages to market value and that the "fortuity" of the PUC making a market value determination controlled the damages, regardless of the actual market value of a REC. The Court explained it could not enforce provisions where there is an "unbridgeable discrepancy between the liquidated damages provisions as written and the unfortunate application in reality," and further, that the provision was unreasonable because it had no "rational relationship to actual damages."
This analysis indicates that efforts to forecast a reasonable actual damages amount at the time of contracting may be trumped by whether the liquidated damages provision ties to actual damages at the time it is applied. Indeed, when the FPL-TXU contract was negotiated, the provision was arguably reasonable—there was not yet a marketplace for RECs and the $50 was pulled from the applicable regulatory scheme. This provision only became unreasonable after contracting when the market value of a REC resulted in a disparity between actual damages and liquidated damages.